Former President George H.W. Bush celebrated his 90th birthday in June by parachuting from an airplane… so, whether or not you agree with his politics, you have to admire his guts in old age. And his plunge is a good metaphor for whether investors should consider taking on additional, measured risk with their investment allocations in retirement… so today, I’m going to share some new thinking retirement investing that defies long-held views.
See, typically, people are told to decrease their exposure to stocks as they near retirement and move to safer investments such as bonds so their retirement savings don’t get wiped out by a 2008-like stock market plunge, and then keep gradually tipping more towards bonds, the older they get.
But a well-written article in the November 2014 issue of Consumer Reports Money Adviser explores the idea of gradually increasing your exposure to equities in retirement, and says, adding more as we age may, paradoxically, make us more financially secure. So I read on and here’s what I found.
..gradually increasing your exposure to equities in retirement, adding more as we age may, paradoxically, make us more financially secure
A new approach to retirement investing
In the first bucket – what I like to call the “expense bucket” – you keep enough to cover a year’s worth of expenses in cash or money-market funds. That’s the secure, pay-the-bills money. In your second bucket – the “bond bucket” – you have short- and medium-term bond investments that are used to replenish the first bucket as it empties each year. The third bucket is your “equity bucket” and holds stocks, equity mutual funds and the like – it’s the most risky portion of your holdings but also provides the most potential for growth.
Now… traditionally, planners have recommended rebalancing regularly so that the second bucket – bond bucket – becomes larger over time and reduces your exposure to risk so you have more for big expenses such as nursing care.
But new thinking on the subject says that while it is very important to build-up a solid principal base as you head into retirement, you may be better off over the long-run – i.e. the next 30 years or so in retirement – if you gradually dial-up the equity allocation in your retirement portfolio… say from about 30% in stocks to 60% over the next few decades… to reduce the likelihood of running out of money in retirement.
That’s because the proven long-term outperformance of stocks – relative to bonds and all other asset classes – would enhance your annual returns which would more than make-up for any big stock-market swings later in life.
By the way, researchers arrived at this new “equity dial-up” approach after stress-testing portfolios under different stock and bond allocations and assumed that retirees withdrew 4% of their savings in the first year and gradually increased that percentage to keep up with inflation.
The benefits of dialing-up equity allocation as you age
Proponents of this new approach say the gradual increase in stock allocations every year also takes advantage of dollar-cost averaging, the keystone of preretirement investing where… when prices are low you get more shares; when prices rise you get less; and, overall, you pay less per share than if you try to time the market.
People who oppose this new approach point out that bonds usually lose only about 5 to 10 percent of their value when interest rates rise, and typically recover more quickly than stock-market dips. Opponents also say that the potential for steep losses is much greater when holding stocks… and that’s true… so you have to balance risk and reward under this new approach.
The Consumer Reports article also offers an easy way to implement this new “equity dial-up” strategy where you actively rebalance 1% of your money into stocks every year, from bonds. Alternately, of course, you could just leave the stock bucket alone and spend from the bond bucket each year, which will shrink over time as you take out 4% + inflation each year.
Now, I know this strategy is not for everyone… and, I know, a lot of new retirees – especially those who suffered big losses in 2008 – might prefer the safety of bonds, and that’s fine too – because you should always be comfortable with your fundamental approach to investing, specially in retirement when you’re no longer getting a regular paycheck.
So here’s what you should do… talk to your financial advisor; look at how much you’ll likely have in principal savings as you enter retirement; assess your household expenses; factor in inflation; add a buffer for vacation spending and one-off expenses such as replacing an old car, etc.; see what your medical insurance policies cover and what your maximum out-of-pocket exposure is; then, based on your retirement savings and needs, figure out what really matters to you – maximizing wealth or minimizing downside? And see if this “equity dial-up” strategy makes sense for your retirement needs.